Managed funds (or their U.S. mutual fund counterparts) are the primary vehicle for the majority of individuals’ investments in share and fixed interest markets and, to a lesser extent, property markets. By pooling the funds of many investors, they offer a number of potential benefits (compared with an individual investing directly in the relevant asset class).
* Diversification across a broad range of individual investments;
* Economies of scale and reduced transactions costs; and
* Access to professional fund managers.
However, the mechanics of managed funds are not generally well understood by their investors. This article focuses on two aspects of managed funds: structure and unit pricing. Both can be sources of confusion and potential tax surprises for the uninformed investor.
Managed funds are unit trusts
Managed funds are structured as unit trusts, with investments owned by a trustee on behalf of and for the benefit of unit holders. Each financial year, to avoid being taxed on earnings at the top marginal tax rate, managed funds distribute to unit holders:
- all dividends/distributions received on their underlying investments during the financial year, less relevant fund expenses; and
- all realised capital gains, after netting off any available realised capital losses.
The investors or unit holders are then taxed on these distributions, which retain their underlying character, based on their individual tax circumstances.
Unrealised capital gains are not taxed (nor distributed by the managed fund), while realised capital losses in excess of realised capital gains must be retained in the managed fund until future gains are available to utilise them.
These arrangements are consistent with the taxation treatment of all trusts. But for those unfamiliar with them, their consequences may surprise.
For example, assume in a particular financial year the share market rose 10%. Two managed share funds achieved the same 10% total return for the year, but their split between income distribution and growth are entirely different.
Fund A paid distributions of 3% for the year, implying growth of about 7%, for its total return of 10%. Fund B paid distributions of 9%, with growth of about 1%. The most likely explanation for these differences is that Fund B realised more capital gains than Fund A. Trust taxation treatment dictates the distribution of these gains to unit holders. So while both funds achieved the same pre-tax returns, the after-tax positions for unit holders is vastly different.
As a second example, consider hedging against exchange rate risk in managed international share funds. If the hedging is profitable in a particular year (e.g. a fall in the value of international shares due to a rising $A is offset by a corresponding gain on a forward foreign exchange contract), the realised currency gain on the hedging is included in cash distributions to unit holders. It cannot be offset by the unrealised fall in the value of the investments. So the taxable income of investors is increased.
If the currency gain is subsequently reversed the following year with an income loss created by hedging, this loss can be offset against distributions received and realised capital gains for that year. But if these are insufficient to absorb the loss, it must be carried forward in the fund i.e. it cannot be offset against investors’ other income.
Despite no net currency movement over the two years, the effect of hedging in this case is to bring forward tax payments that may take some time to claw back since “losses” are trapped in the trust structure. This negative of protecting against currency exposure in managed international shares is discussed further in our article, “International shares: To hedge or not to hedge?”
Unit pricing practice may lead to distribution surprises …
Managed fund prices are adjusted to reflect both capital movements of and distributions received from the underlying investments of the fund. For a managed fund unit priced at a $1 at the start of the financial year, growth in the underlying investments of 5% for the year and distributions received of $0.04 will result in a price of the unit on the last day of the financial year of $1.09.
On the next day, assuming no growth in the underlying investments of the fund, the unit price immediately falls to $1.05 because the distributions of $0.04 are due and payable to those investors holding units at the end of the financial year.
Now this pricing mechanism may lead to a nasty tax surprise for some investors. If you bought a unit in the above fund at the end of the financial year, it would have cost you $1.09. The next day, the value of your unit drops to $1.05. A few days later you receive a distribution of $0.04. Assuming the distribution is taxed at the top marginal tax rate of 46.5%, an after-tax investment of $1.09 turns into an after-tax $1.07, over a 24 hour period!
The message to take is that as a distribution date approaches an investment decision needs to trade off the cost of turning capital into income against foregoing potential investment growth by delaying investment until after the ex-distribution date.
Managed funds’ mechanics matter
To maximise the tax efficiency of a managed fund, you really need to understand the fund’s approach to tax management and take into account distribution dates. While managed funds are generally a smart wealth management choice for most personal investors, without a good understanding of their mechanics you may be paying more tax than you need to.